When Stock Pickers Stop Picking Stocks

Picking stocks has become so hard that some stock pickers have given up pretending to try.

Pry open the hood of a mutual fund, and you might be startled by what you find. In the past, you would have seen roughly 100 stocks, each painstakingly selected by a portfolio manager passionate about beating the market. Today, you’re increasingly likely to find a few handfuls of exchange-traded funds — those autopilot portfolios that seek to mimic the market rather than beat it.

This evolution in how mutual funds are being run changes the relationship between funds and their investors. Some folks might respect the intellectual honesty of a money manager who has climbed off the hamster wheel of trying to beat the market. Other investors might feel they aren’t getting their money’s worth if they’re paying for active management but their fund manager largely picks other funds instead of individual stocks.

Robert Bacarella, co-manager of the Monetta Young Investor Fund, is one stock picker who has scaled back on picking stocks. “The future is for more and more fund managers to take advantage of ETFs,” he says. “Stock selection is too great a risk.”

Mr. Bacarella still has half his fund’s $110 million of assets in individual stocks including Walt Disney Co. and Amazon.com. But he keeps 50% in ETFs “to control uncertainty and generate consistency.”

With up to nine-tenths of stock pickers trailing the market, “half of my fund will beat 90% of managers over time,” he says.

“If you like banks, why try to pick which one is going to go up more than the others?” Mr. Bacarella says. With an ETF, you can “just buy ‘em all.”
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Isn’t it ironic for a stock picker to talk like this?

“Controlling risk and getting performance consistency relative to the market, that’s what managers can’t do very well, and that’s what ETFs help with,” he says.

Of course, most professional investors insist they excel at managing risk and generating consistent returns. But, as Mr. Bacarella suggests, they haven’t covered themselves in glory pursuing those goals.

Over the past decade, 80% of mutual funds specializing in big U.S. stocks underperformed the S&P 500 index, S&P Dow Jones Indices found last year; 87% of funds investing in mid-sized stocks and 81% of those owning small stocks fell behind their benchmarks as well.

Fees at the Monetta Young Investor fund are relatively low, at 0.55%, or $55 per $10,000 invested. Mr. Bacarella says it charges less than the more “normal” 0.95% management fee at its sibling portfolio, the Monetta Fund, because Young Investor has half its assets in ETFs.

Mr. Bacarella is far from alone in scaling back stock picking in favor of holding ETFs. According to Morningstar, the investment research firm, 18% of stock, bond or “allocation” funds (which include the target-date funds popular in 401(k) plans and own a blend of assets) hold ETFs, up from 13% in 2010. The funds that own ETFs have an average of 20% of their assets in them.

Allocation funds that hold more than half their assets in ETFs charge an average of 0.6% in annual management fees — not much less than the 0.7% average for active U.S. stock funds, Morningstar says. That means some allocation managers are charging almost as much to buy a few ETFs as active stock pickers researching hundreds of individual securities.

USAA Asset Management Co., which runs about $66 billion in mutual funds, holds at least $4 billion of ETFs, says Lance Humphrey, a portfolio manager at the San Antonio-based firm.

As of 2013, USAA Global Managed Volatility Fund, which seeks to capture the returns of stocks around the world but with less risk during downturns, owned more than 600 stocks and bonds. Now, the nearly $200 million portfolio has all its money invested in 19 ETFs.

​“The use of ETFs allows us to implement our views in a quicker and more efficient manner,” he says. Instead of having to trade dozens or hundreds of individual securities, which can be expensive and annoyingly slow, the managers can move frictionlessly in and out of ETFs.

How you should feel about that depends on whether you want your portfolio manager to try picking the best stocks one at a time or to pick from among the same broad bundles of stocks you could buy yourself through an ETF.

With fund companies’ fees and profits on the wane as more investors abandon hope in stock picking, be on your guard: Make sure you don’t end up paying your fund manager even more money to buy ETFs than it would charge you to pick stocks.